My firm has FCF = 1000 and is unlevered. The required return as an unlevered firm is r_u = 10%. FCF is a level perpetuity.

Shareholders have been clamoring for some increase in debt. The firm announces the following strategy:

• We will permanently issue $500 of debt,
• We will also issue another $500 of debt, but we will pay off $100 of that debt at the end of each year for the next 5 years. The combined debt proceeds will be used to pay a dividend to shareholders.
• All debt is assumed to be AAA quality and has no risk of default and zero beta and the borrowing rate is 5%

The corporate tax rate = 25%.

1. Assume no distress costs and no impact of personal taxes or liquidity on the required return on debt. This implies that the debt has the same required return as a stock with beta = 0. What is i) PVTS, the present value of tax savings from the debt issues, and ii) Value of the levered firm: (VL = Debt + Equity) after the debt is issued and dividends are paid.

NOTE: You can figure out the value of the PVTS for debt issued under each strategy and add them together to get total PVTS at the corporate level

2. The above question presumes that AAA borrowing was at 5% which is the same required return as risk free/zero beta equity. If the AAA borrowing rate for debt was 5.3% and higher than the required return on zero beta stock, would that change the value of the levered firm, VL (and how)?